Second Circuit Clarifies Loss Causation and Proximate Cause Standards by Holding that Negative News Articles and Director Resignation Do Not Give Rise to Section 10(b) Liability Without "New" News

January 1, 0001


On March 9, 2010, the Second Circuit made it more difficult for securities-fraud plaintiffs to prove the "loss causation" element of a Rule 10b-5 claim in In re Omnicom Group, Inc. Sec. Litig.[1] In affirming Southern District of New York Judge William H. Pauley III's summary judgment ruling in favor of the defendants, the Court clarified the Second Circuit's approach to what constitutes a "corrective disclosure" under the Supreme Court's decision in Dura Pharmaceuticals v. Broudo.[2] The Second Circuit held that negative news that caused a stock price decline cannot give rise to liability under section 10(b) of the Securities Exchange Act if the "news" did not disclose new information.

An essential element of a Rule 10b-5 claim is "loss causation," which requires the plaintiff to establish that the alleged fraud caused his economic harm. In Dura, the Supreme Court held that the plaintiff can recover only for that portion of his lost stock value that he can prove is attributable to the misrepresentation, rather than price declines caused by new economic circumstances, changed investor expectations, or other events. Since Dura, courts in the Second Circuit and elsewhere have held that to establish the "loss causation" requirement and survive summary judgment a plaintiff must either (1) identify a "corrective disclosure" revealing the fraud to the public followed by a significant decline in stock price, or (2) show that the events causing the investor losses were a foreseeable consequence of the fraud and within the zone of risk the securities laws were designed to prevent.

In Omnicom, the defendant issuer tried to reduce its losses from investments in various internet advertising companies (together called Seneca) by shifting ownership to a separate company. Several media outlets covered the Seneca transaction when it occurred in May 2001, and in March 2002 Omnicom disclosed in a Form 10-K that it had recorded no gain or loss on the transaction. A year after the transaction, on June 5, 2002, Omnicom filed a Form 8-K stating that the chair of its board audit committee had resigned. On June 12, 2002, the Wall Street Journal published a negative front-page story about Omnicom's accounting practices, highlighting the director's resignation, quoting two accounting professors who (based on public filings) said that the Seneca transaction raised a red flag, and making ominous comparisons to the Enron and Tyco scandals. After the article and subsequent media coverage, Omnicom's stock price dropped, losing nearly 20% in just a few days. The stock price eventually rebounded, but not before the plaintiffs' bar had filed suit. Five-and-a-half years later, the district court granted summary judgment to the defendants, holding that plaintiffs could not establish loss causation because the articles precipitating the stock-price drop did not contain a corrective disclosure.

The Second Circuit affirmed. The Court held that the plaintiffs' reliance on the fraud-on-the-market theory made it "difficult" to establish loss causation when the alleged fraud occurred more than a year before the stock price decline.[3] Since that theory presumes that the market "promptly" digests new information, the plaintiffs could only prove loss causation by either (1) identifying a corrective disclosure that revealed the fraud and was the but-for cause of the price decline, or (2) showing that negative investor inferences drawn from the director resignation and the news stories were a foreseeable materialization of the risk that the fraud concealed.[4] The Second Circuit held that the plaintiffs could not prove loss causation on either theory because no new news was revealed in the "corrective disclosures" that the plaintiffs identified.

First, the Court reasoned that none of the plaintiff-identified news reports constituted corrective disclosures, because none contained any new or additional news. The Court specifically pointed to the fact that Omnicom's use of the Seneca transaction to remove losses from its books was known to the market a year before the director resignation. The news articles that immediately preceded the stock decline were nothing more than "a negative characterization of already-public information," and "[a] negative journalistic characterization of previously disclosed facts does not constitute a corrective disclosure of anything but the journalists' opinions."[5]

Second, the Court observed that the negative media attention surrounding the director's resignation, while perhaps having a temporary dampening effect on Omnicom's stock price, did not contain any previously-undisclosed information and so was not a foreseeable materialization of a risk that the fraud concealed. General negative media attention, without new previously undisclosed information, is too speculative to satisfy the loss causation requirement under Rule 10b-5. The Court held that companies cannot be "required by the securities laws to speculate about distant, ambiguous, and perhaps idiosyncratic reactions by the press or even by directors. To hold otherwise would expose companies and their shareholders to potentially expensive liabilities for events later alleged to be frauds, the facts of which were known to the investing public at the time but did not affect the share price, and thus did no damage at the time to investors."[6] The Second Circuit explained that "[a] rule of liability leading to such losses would undermine the very investor confidence that the securities laws were intended to support."[7] In other words, a director resignation that causes a media stir and a temporary stock-price decline, without any hard news about the reasons for his resignation that reveal the fraud, cannot give rise to liability under the securities laws.

Omnicom is significant because it holds that negative news coverage cannot give rise to liability if it is not accompanied by some new information revealing a fraud for the first time—no matter how the news affects the stock price. As a practical matter, Omnicom makes it more difficult, if not impossible, for plaintiffs to succeed in cases where the alleged fraud occurred well before the stock price decline.

[1] Case No. 08-0612-cv, 2010 WL 774311 (2d Cir. March 10, 2010).

[2] 544 U.S. 336 (2005).

[3] 2010 WL 774311, at *8.

[4] Id.

[5] 2010 WL 774311, at *9.

[6] Id. at *11.

[7] Id.